Why Would a Call Buyer Exercise, Rather than Sell, an In-The-Money Call Option?

When we write a covered call, there is a trader or market-maker buying that call on the other side of the trade. We know that as expiration approaches, the time value of options tends to approach zero (Theta effect). With that in mind I received an email from Marcos in early May 2017 astutely asking why a call option buyer would ever exercise an in-the-money call with little or no time value to capture intrinsic value. As we evaluate this scenario, let’s assume the call buyer does not want to own the stock in a long-term buy-and-hold portfolio.

Reason not to exercise

Exercise and then sale of the stock will result in one additional commission, maybe more

To capture the intrinsic value remaining in this in-the-money strike, the call buyer can sell the option resulting in one commission. To exercise and then sell the stock, to capture that same intrinsic value, there will be two commissions, one to buy the stock and one to sell the stock. Some brokerages will charge an additional or higher commission fee when exercise is involved (avoid these brokerages!).

Reason to sell option

All intrinsic value and any small amount of time value (may be none) is captured and exercise (buying the shares) is avoided (exercise by exception…see below).

Exercise by exception versus automatic exercise

Exercise by exceptionis the administrative procedure whereby the OCC (Options Clearing Corporation) exercises all in-the-money strikes by the threshold amount (usually $0.01 or more) unless the member submitted instructions not to exercise. This process is frequently incorrectly referred to asautomatic exerciseignoring the fact that the clearing member always has the right not to exercise.

When is exercise of in-the-money strikes more likely?

In-the-money strikes may be exercised prior to contract expiration when an ex-dividend date comes up prior to but near expiration and the future dividend distribution will be greater than the time value remaining in the option premium. Let’s view a real-life example for KLA-Tencor Corp. (KLAC). On May 10, 2017, KLAC was trading at $100.16 and the $97.50 in-the-money strike had a published bid price of $2.50 as shown in the screenshot below:

KLAC Options Chain on May 10, 2017

The $97.50 was trading at a published bid of $2.50, all intrinsic value, and no time value component. Next let’s research the ex-dividend date and dividend amount at www.dividendinvestor.com:

KLAC Dividend Information as of May 10, 2017

With the ex-date due the next day, May 11th (yellow field), we see the quarterly dividend distribution will be $0.54 (1/4 of $2.16 in the brown field). In this case, exercise will result in capture of $54.00 per contract above time value ($0.00). This is an example where early exercise (the day prior to the ex-date) is more likely.

If there was a time value component above the intrinsic value, the option holder would have benefitted even more by first selling the option and then buying the stock prior to the ex-date to capture the dividend.

3 PM ET: Online event. Alan will be a featured speaker at MoneyExpo, which is the largest online-only premier event for traders and investors across all traditional asset classes. Registration link and information to follow.

October 10, 2017: Palm Beach Gardens Florida:

7 Pm to 9 PM

Using options to Generate Monthly Cash and to Buy a Stock at a Discount.

LOCATION: Publix Greenwise Market (2nd floor)

11231 Legacy Avenue (Legacy Place)

Palm Beach Gardens, FL 33410

The club charges $10 at door to cover expenses.

Market tone

Global stocks were little changed this week as markets digested escalating tensions on the Korean Peninsula and the potential impacts of hurricanes Harvey and Irma on the US economy. The price of a barrel of West Texas Intermediate crude oil rose to $48.95 from last Friday’s $46.75. Volatility as measured by the Chicago Board Options Exchange Volatility Index (VIX), advanced to 12.12 from 10.3. This week’s economic and international news of importance:

Hurricane Irma, a Category 5 storm is set to make landfall this weekend in south Florida. US economic data is likely to be impacted by the recent storms

Southern Mexico was shaken by an 8.2- magnitude earthquake, the strongest to hit the country in a century

The US Federal Reserve’s seven-member Board of Governors is now down to just three members, with Vice Chair Stanley Fischer this week resigning. Nominee Randal Quarles awaits confirmation

President Trump struck a deal with congressional Democrats to extend the debt ceiling and fund the government for three months while providing Harvey relief funds for Texas and Louisiana

Markets were negatively impacted early in the week as Kim Jong-un’s nuclear program continued to advance rapidly

The European Central Bank did not adjust monetary policy at its September meeting, but it did up its 2017 economic growth outlook to 2.2% from an earlier 1.9% forecast

THE WEEK AHEAD

Mon, Sep 11th

Tue, Sep 12th

Wed, Sep 13th

UK: Unemployment and average earnings

Eurozone: Industrial production

Thu, Sep 14th

China: Retail sales and industrial production

Japan: Industrial production

UK: Interest rate meeting

US: Consumer Price Index

Fri, Sept 15th

US Retail Sales

US Industrial production

For the week, the S&P 500 declined by 0.61% for a year-to-date return of 9.94%